Chaper 8/9 Flashcards
What is the drawback of markowitz’s model?
- in large portfolios with large number of assets number of parameters required for calculations exploded
Describe main assumptions of CAPM
- investors optimise portfolios a la markowitz
- investors use identical input list for efficient frontier
- investors calculate identical efficient frontiers of risky assets
- all investors hold same portfolio for risky assets
What is the market portfolio?
- aggregation of all risky portfolios and has same weights
- tangency portfolio on the efficient frontier
- contains all securities
What is the basic principle of equilibrium in CAPM?
- all investments should offer the same Sharpe ratio
- otherwise pressure security prices until ratios equalised
What is the beta coefficient
- measure of a security’s sensitivity to movements in the market
- b= 1 - market portfolio
- b>1 - aggressive stock (amplify overall movements of the market)
- b<1 - passive stock (move in same direction as market but not as far)
What does the security market like represent?
Expected return - beta relationship
What is the slope of SML?
E(rm) - rf
= market risk premium
What is the relationship between SML and price of assets
- fairly priced assets plot exactly on the SML
- in market equilibrium all securities lie on SML
Describe deviations from SML
- deviations provide arbitrage opportunities
Underpriced sticks plot above SML
- greater returns than predicted - “good to buy”
Overpriced sticks plot below SML
- lower returns than predicted - “good to sell”
Deviations from SML = alpha
Describe the potential real world problems with CAPM
Correlated errors
- groups of companies affected by common shocks
Errors-in-variables
- beta coefficients are estimated and therefore contain sample error
Rolls critique
- market portfolio not observable
What is the benefit of single index model
- dramatically reduces the number of parameters required for portfolio analysis
What are the main assumptions of single index model?
- returns on sticks tend to change in a similar fashion as the average return in the market
- deviations of stock returns from their expected values (firm-specific risk) are uncorrelated with returns on the market (systematic risk)
- deviations of sticks returns from their expected values are uncorrelated with each other
- expected value of residual (firm-specific risk) = 0
What is another measure of beta?
Coefficient of determination (R-Squared)
- indicates % of returns variance explained by market factors
- R-Squared=correlation coefficient squared
What is liquidity?
- the ease and speed with which wan asset can be sold at fair market value
What is the illiquidity premium?
- discount from fair market value the seller must accept to obtain a quick sale
